Sunday, August 24

Week 164 - Our Approach To Picking Stocks For Retirement Income

Situation: What’s the plan? How big a part should ownership of individual stocks play in your retirement savings? How should you pick those? How should you sell those?

We suggest that you plan to depend on "compound interest" to build financial security for you and your heirs, not "capital appreciation" (which is always a gamble in the absence of dividend growth). With few exceptions (see Week 150), stocks need to be backed 1:1 with US Treasury bonds (or mortgage agency debt instruments). Pick stocks by following these guidelines:

First, you’ll need a way to find companies with improving fundamentals. For us, that information can be found on the annual Barron’s 500 List, which ranks the 500 largest companies (by revenue) that are listed on the New York and Toronto stock exchanges by using 3 equal-weighted criteria: sales growth over the most recent year, growth in cash-flow based return on invested capital (ROIC) over the past 3 yrs, and the most recent year’s ROIC divided by median ROIC over the past 3 yrs. We’re most interested in companies that move up in rank year-over-year but we also value those that consistently place in the upper 2/3rds of the Barron’s 500 List (see Week 159). 

Second, you’ll need a way to determine whether or not a company’s management has a primary goal of benefitting all shareholders (as opposed to themselves). Has the company a) raised its dividend annually for at least the past 10 yrs, and b) maintained an S&P bond rating of BBB+ or better? 

Third, does the stock appear to be undervalued relative to risk? For that point, we calculate Finance Value (long-term reward minus Lehman Panic losses) to be sure that it beats the Finance Value for the Vanguard Balanced Index Fund (VBINX), as well as looking to be sure that both the 5-yr Beta and P/E do as well as VBINX.

Fourth, is the company’s dividend growth rate plus its current dividend yield greater than 7%? That would suggest that the “business case” for making the investment (doubling one’s money in 10 yrs) applies.

Fifth, stay on top of the “story.” In other words, what’s supporting the stock price vis-a-vis reported 12-month earnings (P/E). If the P/E is outside the normal range of 10-20, you need to be concerned. The story might be broken (low P/E) or outdated (high P/E).

Sixth, what about a Plan B? Do alternative investments like real estate (owned for rental income), gold (owned for capital appreciation), or commodity futures (owned for gambling that the underlying commodity will change dramatically in price over the near term) make sense? We don’t think any of those alternatives have a low enough risk to justify inclusion in a retirement portfolio. That leaves our benchmark, The Vanguard Balanced Index Fund (VBINX), as the only alternative investment. This week’s Table shows the 17 companies that pass our filter. Red highlights denote underperformance relative to VBINX

Selling stocks that you’ve chosen by using these guidelines shouldn't become an issue if you’ve set up a Dividend Reinvestment Plan (DRIP) and add a small fixed amount of money to it regularly. That will capture “reversion to the mean” pricing. You benefit from the additional shares that a fixed amount of money buys for you whenever the price is down. That said, you will have to sell if the stock fails to meet the above criteria for extended periods. But as long as the company keeps raising its dividend every year enough to beat inflation, there’s little need to worry. We encourage you to think of your DRIPs as a growing perpetuity, which is a type of bond that keeps paying more interest every year. You don't care about the stock's price as long as the company is committed to increasing its dividend every year regardless of economic conditions.

However, the guidance I’ve just given isn’t going to satisfy all of you, so let’s use a golf analogy. The ball has landed off the fairway, out in the weeds: That’s how you feel about the stock because it has fallen in value compared to what you’ve paid for it. You’ll need to exercise due diligence and study the “story” that has been supporting the stock’s price: Has the price fallen because the story is broken? Or has the price fallen because of macroeconomic events that have little impact on the company’s prospects and the story remains intact? Decide whether or not you’d like to continue buying the stock. That decision process takes time to gestate but if at the end of that time you decide you are no longer a buyer then you are a seller. Finally, you’ll need a “tickler,” some kind of alert that stockpickers use to keep from getting very far into the weeds. The one I like is “sell if you’re down more than 90 days.” So, check your positions every 3 months and do some thinking about the losers. But beware, once you become a trader you're returns will increasingly align with capital appreciation rather than dividend growth. You'll get more thrills, and more sinking feelings.

Bottom Line: We've found 17 stocks that meet our criteria as of this writing (7/18/14), given that the goal is to have dividend income during your retirement years that is likely to grow faster than inflation. 

Risk Rating: 4

Full Disclosure of my current or planned purchases of stocks in the Table. I dollar-average into NEE, PG, WMT, and JNJ each month at computershare.

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